Pull out your pad of paper and #2 leads pencils. It’s time for a quiz!
Facts: Greta Grantor has three children, all with their peculiarities (she loves them all, but she trusts none of them with money). She has elected to fund an inter vivos trust for the benefit of her precious angels. During her life she wants to insure that principal and income are available to be distributed “as needed” from a common fund to the children. Distribution decisions are totally within the discretion of the trustee, subject only to the usual fiduciary standards of reasonableness and good faith. At her death the trust is to be distributed in equal shares for her grandchildren (with appropriate holdback provisions for the younger ones).
Goals: You have determined that it is important for this to be a grantor trust during Greta’s life (the reason really isn’t important to our inquiry). She is concerned about Medicaid qualification in the distant future and “just wants to get the five-year clock ticking.” It is also important that she have little to do with distribution decisions or significant retained powers with respect to the trust for Medicaid purposes.
Greta has asked you to name her nephew Chip (who is a CPA and very well-suited) as trustee.
OK, class, here’s the question: Have you accomplished your tax goals? Is this a grantor trust? By the way, do NOT assume the existence of any trust terms that I haven’t given you.
WHEN YOU THINK YOU HAVE AN ANSWER, SCROLL DOWN.
Analysis: How, you may ask, can this be? After all, the children are the only adverse parties, which would make Chip a nonadverse party with discretion to make distributions. Look at IRC § 672(a), (b) for definitions of adverse and nonadverse party. It’s straight-forward: An adverse party is one affected by the exercise or nonexercise of a power that he or she possesses; a nonadverse party is some who is not adverse.
As you may have known, the starting place is, indeed, IRC § 674(a). That subsection says simply that
The grantor shall be treated as the owner of any portion of a trust in respect of which the beneficial enjoyment of the corpus or the income therefrom is subject to a power of disposition, exercisable by the grantor or a nonadverse party, or both, without the approval or consent of any adverse party.
That’s all that is going on here, right? Well . . . no. The rest of IRC § 674 is essentially a laundry list of exceptions and exceptions to the exceptions.
Enter the “C” Trust
Subsection 674(a) does not apply to a power exercisable solely by an independent trustee (without the approval or consent of any other person) to distribute, apportion or accumulate income, or to distribute corpus among a defined class of beneficiaries. IRC § 674(c).
That’s it, pilgrims! This is NOT a grantor trust.
Why is this NOT a Grantor Trust?
Because Chip is an “Independent Trustee.”
IRC § 674(c) refers only to a trustees who are not “related or subordinate parties” who are not “subservient” to the grantor. The regulations flesh this out, as they are wont to do. Treas. Reg. § 1.674(c)-1 refers inquirers back to IRC § 672(c) for definitions of “related or subordinate parties” and “subservient.”
IRC § 672(c) says that a related or subordinate party is
the grantor’s spouse if living with the grantor . . . [or] any one of the following: The grantor’s father, mother, issue, brother or sister; an employee of the grantor; a corporation or any employee of a corporation in which the stock holdings of the grantor and the trust are significant from the viewpoint of voting control; a subordinate employee of a corporation in which the grantor is an executive.
Hmmm. Doesn’t look as if the Chip-meister fits this definition. So, he’s “independent.”
How to Bust a “C” Trust
By the way, if you are trying to AVOID grantor trust status but would like to maintain some flexibility, this is a great way to do it.
However, if you WANT it to be a grantor trust but you like these distribution provisions, or you really want it NOT to be a grantor trust and want to make sure you don’t accidentally cancel-out the “C Trust” status, you better understand a few extra rules.
First of all, the trustee’s discretion must be exercised “without the approval of consent of any other person.” IRC § 674(c). If you subject the discretion to the approval of some other nonadverse person who is NOT a trustee, you will have either “ducked a bullet” (if you wanted a grantor trust to begin with) or “messed up big time” (if you didn’t want a grantor trust).
By the way, why is the status of the other person as a trustee important? Because the beautiful (or offending) power applies only to the exercise by a trustee.
Similarly, if the grantor has the right to remove a trustee and replace the trustee with another trustee who might not be independent you have saved/dashed your plans. This one is REALLY buried in the regs: Treas. Reg. § 1.674(d)-2(a).
Finally, you can dash/save your plans be giving any person the power to expand the defined group of beneficiaries beyond after born children. Giving the trustee, or an adverse party, or a nonadverse party (including distant cousin Brunehilde) the authority to add some beneficiaries (perhaps, for example, in-laws) will do the trick.
Remember: You WANTED to go to law school!
By the way, this is just the type of thing we cover in the TrustChimp Trust Summits. Find out more and give one a whirl!
What if she lived in a jurisdiction where all trust were revocable unless expressly made irrevocable
Bob Mason says
Ah, ah, ah, Fred. You’re assuming facts I didn’t put in there. But even if that was the case, if I was worried about Medicaid and “getting the five year clock ticking” I wouldn’t draft a revocable trust . . . unless I had my malpractice carrier on speed-dial!
You’re. scaring. me. I have no idea why client would want a Grantor Trust or WOULDN’T want a grantor trust. so much to learn. Hope the summit gets me closer to the top….
Bob Mason says
BWWAAAHAHAHAHAHA! Chill Once you’re a proud and exhausted Summit grad you’ll understand all this stuff.
Robert balter says
But Chip can make distributions that might discharge support obligations since we were told not to assume an upjohn provision.
Bob Mason says
Well . . . there’s a narrow view and broader view of Upjohn (please don’t ask for a cite, but Upjohn was a case having to do with ability of a trustee/beneficiary to make distributions satisfying a support obligation of the beneficiary/trustee . . . or was it an obligation of the grantor/settlor . . . I don’t recall without peeking). What you’re referring to (for the benefit of other readers) is that IRC sec. 674(b)(1) and 677(b) grantor trust status if income is, in fact, distributed to meet a support obligation (the mere presence of such a clause enabling the trustee to do so won’t cause a grantor trust).
In my facts, the trustee wasn’t a beneficiary. I guess one of the three beneficiary children could be the source of a support obligation of the settlor . . . but NO! I’m going to make up another fact . . . all the beneficiaries are adults and Greta Grantor has no support obligation.
Maureen Ward says
I’m really looking forward to the summit!
I don’t understand why the children are adverse parties since they hold no powers themselves (only the right to income and corpus). But if they are adverse parties, aren’t the grandchildren adverse parties, too?
Bob Mason says
The children (and grandchildren, as you observed) are adverse because they would be affected by an exercise (or non-exercise) of the discretionary powers the trustee has. That is why you don’t want one of them to be trustee (or maybe you do, depending on what you’re trying to do). In this case Chip is definitely nonadverse . . . And independent.
Bob Mason says
By the way, all of this will be perfectly clear to you by this time next week. See you at the Summit!
Maureen Ward says
Right now, I’m claiming the position of “lowest common denominator” so appreciated Doris’ comments. Thanks.